Inflation risk

Inflation risk occurs when inflation increases, but the return on one s investment does not keep pace with it. An example might be your savings account paying 1 percent interest when inflation is 3 percent. Business-cycle risk refers to the fact that your investments may mirror the fluctuations in the business cycle. For example, stocks typically decline when the economy first enters a recession because the earnings of companies normally decline during recessions. Interest-rate risk may occur when interest rates rise, but you have locked into a lower rate on a long-term bond. For example, if you purchase a 4 percent bond for 10 years, you face the... 

Index-linked or inflatiOTi-indexed bonds present additional issues in their analysis, due to the nature of their cash flows. Measuring the retimi on index-linked bonds is less straightforward than with conventional bonds, and in certain cases there are peculiar market structures that must be taken into accotmt as well. For example, in the United States market for index-linked treasuries (known as TIPS from Treasury Inflation-Indexed Securities) there is no significant lag between the inflation link and the cash flow payment date. In the United Kingdom, there is an 8-month lag between the inflation adjustment of the cash flow and the cash flow payment date itself, while in New Zealand there is a 3-month lag. The existence of a lag means that inflation protection is not available in the lag period, and that the return in this period is exposed to inflation risk it also must be taken into account when analysing the bond. 

Traditionally, information on inflation expectations has been obtained by survey methods or theoretical methods. These have not proved reliable however, and were followed only because of the absence of an inflation-indexed futures market. Certain methods for assessing market inflation expectations are not analytically valid for example, the suggestion that the spread between short- and long-term bond yields cannot be taken to be a measure of inflation expectation, because there are other factors that drive this yield spread, and not just inflation risk premium. 

One final point regarding duration is that it is possible to calculate a tax-adjusted duration for an index-linked bond in markets where there is a different tax treatment to indexed bonds compared to conventional bonds. In the United States market, the returns on indexed and conventional bonds are taxed in essentially the same manner, so that in similar fashion to Treasury strips, the inflation adjustment to the indexed bond s principal is taxable as it occurs, and not only on the maturity date. Therefore, in the US-indexed bonds do not offer protection against any impact of after-tax effects of high inflation. That is, Tips real yields reflect a premium for only pretax inflation risk. In the United Kingdom market however, index-linked gilts receive preferential tax treatment, so their yields... 

Inflation or purchasing power risk reflects the possibility of the erosion of the purchasing power of bond s cash flows due to inflation. Bonds whose coupon payments are fixed with long maturities are especially vulnerable to this type of risk. Floaters and inflation-indexed bonds have relatively low exposures to inflation risk. 

We have sketched out a couple of reasons why governments issue index-linked bonds already. We also said how the removal of inflation risk is valuable for the borrower, as it is for the investor, and earlier we described how in some countries rampant inflation resulted in a complete loss of investor confidence in nominal government debt, requiring the creation of an inflation-linked bond market out of necessity. However, there are other arguments why governments should issue linkers, and the reasons already given need to be added to, expanded upon and broken down into different subarguments. 

The Fisher equation, which predated the existence of inflation-linked bond markets, states that a nominal bond yield is made up of three components—inflationary expectations, a required real yield that investors demand over and above those inflationary expectations, and a risk premium. The risk premium reflects the assumption that investors want additional compensation for accepting undesirable inflation risk when holding (therefore suboptimal) nominal bonds. 

This may all seem rather convoluted, so a simple example might suffice to make the point clear. Let us assume that the average bond investor expects future long-term inflation to be 2.5%, and that the average investor is inflation risk averse, so be prepared to pay a 0.25% risk premium. On this basis alone, we would expect observed break-even inflation to be 2.75%. Now let us say that the govermnent also has inflationary expectations of 2.5%, but it prefers real liabilities to nominal liabilities, and places a 0.25% yield value on that preference. It will prefer to sell inflation-linked bonds rather than nominal bonds until break-even inflation falls to 2.25%. 

Needless to say, we do not live in a two-asset world, and this complicates matters further. An investor might place a high inflation risk premium on an index-linked bond when only nominal alternatives are available, but the value attributed to the risk premium will also be influenced at least a little by the availability of competing assets offering some degree of inflation protection—the more classic inflation hedges such as real estate and land. 

In practical usage, the inflation risk premium in the standard nomi-nal/real bond Fisher relationship is sidestepped when the formula is reduced to ... 

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